Private wealth - after-tax cash flow on leases

Geri Buylak, a financial advisor, is preparing for a meeting with Kasey McLoughlin, the recent widow of,
Bryn McLoughlin, a resident of the country of Weshvia. From her files of the McLoughlin family, Buylak notes the following which she thinks might be relevant in the meeting:

Kasey was Bryn’s second wife. Bryn has been the sole provider for his grandson Paulo for the past 20 years; Paulo was orphaned at the age of three and initially lived with Bryn and his first wife.
Mainly as a result of the stress arising from the disabilities and medical problems that Paulo developed, Bryn’s first marriage ended in divorce within one year. Two years later, it was determined that Paulo would be better off living in a private care facility in the sunny warm climate of Izlandia where he continues to live today.

To insure that Paolo’s future needs would be met, shortly after the child was orphaned, Bryn purchased a €3 million life insurance policy on his own life for a one-time premium of €500,000. At the same time, Bryn’s father bought a similar, but smaller policy on his own life. Ownership of both policies was transferred to a discretionary irrevocable trust with Paolo as the primary beneficiary and the University of Izlandia as the remainderman.
Buylak was appointed as the investment advisor for the trust.
Bryn and Kasey were married two years after Bryn’s divorce.

Buylak had been faxed a copy of Bryn’s will and in combination with other information she had available made the following notes:

Two years ago, Bryn disposed of his very successful construction company and invested the proceeds in two overseas distribution centers. The first property is located in the country of Landlochen and at the time of his death it was jointly owned with Kasey with the right of survivorship. For the second of these properties Bryn’s will named Paolo as the beneficiary of the property – the property is located in Izlandia where he resides.
Kasey was named the beneficiary of Bryn’s taxable account and two tax advantaged retirement accounts.
Weshvia, Izlandia and Landlochen all use the euro, and none of the three tax regimes impose any tax consequences on spousal transfers either before or after death.

As they begin their meeting, Kasey first asks Buylak if any of the provisions of the life insurance policy or dispositions of the investment properties might be challenged in the probate process.

Kasey mentions to Buylak that she is aware that a large part of her wealth now depends on the investment property in Landlochen and asks Buylak what cash flow would be available to her annually after taxes from its lease income and what after-tax cash proceeds might she obtain if the property was sold when the current lease expires. Buylak had been prepared for these questions and her responses were based on the following:
The investment real estate property in Landlochen had a cost basis of €2,900,000, a present market value of €3,000,000, and it produces income of €450,000 (pre-tax) annually through a lease agreement that expires in five years. By this time, the property will have been owned for seven years.
After reviewing several reports analyzing Landlochen real estate values, Buylak estimates that the property could be sold at the termination of the lease for 30% above its present market value.
The tax structure in Landlochen differs from Kasey’s home country Weshvia as shown in Exhibit 1. Fortunately, there is a provision for some relief from double taxation. Weshvia allows use of the deduction method with regard to income taxes and the credit method toward capital gains.

. Using Exhibit 1, the annual amount of after-tax cash flow that Kasey will earn on the Landlochen property lease is closest to:

  1. €175,875.
  2. €219,375.
  3. €292,500.

Solution

B is correct. In each year, the tax rate under the deduction method will be:

TResidence + TSource(1 − TResidence)

which here is (0.25) + 0.35(1 − 0.25) = 0.5125

This is the combined tax rate net of tax relief via the deduction method.

My questions are:

  1. how do we know Landlochen is under the source jursidiction, and Weshvia under residence?
  2. If we use the deduction method, and Landlochen is source in this case, I thought Landlochen will get its full tax of 35%, and the rest (0,5125 - 0,35) will go to Weshvia.
    Why do we apply the (1-0,5125) tax to a lease in Landlochen, and not 0,35 directly?

Think about what you’re getting relief for - paying taxes 2x so if Landlochen is her home/residence then Weshvia must be the source absent some residence residence conflict

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